How Will Financial Reporting Changes Affect the Valuation Process?
When valuing a private business, financial statements are an important source of information. But recent changes to the accounting rules complicate matters. Here are some major financial reporting changes that are underway — and how they might impact the valuation process.
In recent years, the Financial Accounting Standards Board (FASB) has issued the following three major accounting updates:
1. Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The update requires revenue from long-term contracts to be reported using new principles-based guidance. The changes affect the timing, but not the amount, of revenue reported over the life of a contract. The updated guidance also calls for expanded disclosures regarding the nature, amount, timing, and uncertainty of revenue that’s recognized.
The updated standard has significantly affected certain types of businesses, including construction, software, wireless, and media companies. It went into effect in 2018 for calendar-year public companies and 2019 for private companies and nonprofits. However, the FASB recently gave franchisors that aren’t public business entities the option to postpone implementation until calendar-year 2020 to give them extra breathing room during the novel coronavirus (COVID-19) crisis.
2. ASU No. 2016-02, Leases. The updated standard on long-term leases goes into effect in 2019 for calendar-year public companies and in 2022 for private businesses and nonprofits. It puts leases on the balance sheet, requiring companies to report right-to-use assets and corresponding liabilities for lease obligations. It also calls for expanded footnote disclosures about leasing transactions. These changes will make lessees appear more leveraged than under the prior rules.
3. ASU No. 2016-13, Financial Instruments — Credit Losses. Banks and other companies that lend money to third parties will soon be required to immediately record the full amount of expected credit losses in their loan portfolios. The updated standard transitions from the use of an “incurred loss” model under current practice to a “current expected credit loss” (CECL) model. The change, made in response to the 2008 financial crisis, is designed to provide stakeholders with more timely, relevant information.
Last year, the FASB set the effective date for the credit loss standard as 2020 for calendar-year public companies and 2021 for private ones. However, a provision of the Coronavirus Aid, Relief, and Economic Security (CARES) Act has delayed implementation of this standard to the earlier of 1) the end of the COVID-19 crisis, or 2) December 31, 2020.
Processing the Changes
The FASB has also changed its general philosophy for setting effective dates. Going forward, the effective dates of major updates for small reporting companies (SRCs), private companies, nonprofits, and employee benefit plans will be at least two years after the effective dates for large public companies. Varying effective dates could result in major differences between the financial statements of public vs. private companies when they’re implementing major financial reporting changes.
Financial statements may be used as the basis for projecting future income, estimating discount and capitalization rates, and adjusting the preliminary value estimate for interest-bearing debt. It’s important for valuation experts to understand the accounting rules that the subject company is using — and make adjustments if its accounting methods differ from industry norms or guideline companies used in the market and income approaches. To the extent that the balance sheet has been affected by accounting rule changes, adjustments may also be needed when using the cost approach.
Muddying the Waters
When valuing a private business, experts need to understand the specific accounting rules that the subject company and any guideline companies follow. In some cases, adjustments may be needed to avoid apples-to-oranges comparisons. Contact Bill for more information.